Fiscal policy consists of the use of taxes and government spending in the economy to promote macroeconomic objectives such as full employment, economic growth, low inflation and reduced income inequality. When an economy is doing poorly, the government’s fiscal policies tend to result in large budget deficits, which occur when the amount of expenditures exceed the amount of tax revenue collected in a particular year.

When a government runs deficits year after year, each deficit is added to the nation’s debt. The charts below, created using Google’s Public Data Explorer, provide a snapshot of the deficit and debt situations experienced by the countries of Europe over the last couple of decades. Study the graphs closely with your class, then read the analysis and explanations that follow!

When an economy is doing well, fiscal policy adjusts automatically to bring down deficits, and even allow a government to run a budget surplus if the tax revenues exceed government expenditures. When the economy slows down, output falls, and unemployment rises, government spending and taxation automatically adjust in ways that move the budget towards deficit, in which the government spends more than it collects in taxes.

These automatic adjustments to fiscal policy result from the effect growth or recession have on previously mandated government expenditures and tax receipts. For example, imagine the US economy slips into a recession:

As demand for the nation’s output falls, the incomes of producers and workers decline, therefore the amount of income tax received by the government decreases automatically

At the same time, more workers are becoming unemployed, making them eligible to receive unemployment benefits from the government. More people slip into poverty and begin to receive welfare and government health insurance, and perhaps even subsidized housing and food.

Revenues automatically decline while government spending automatically increases, moving the budget further into deficit.

Next imagine the US economy has recovered and is growing at rates above its long run average growth rate. During such “booms” in the business cycle, the following occurs:

Business and household incomes are rising, so more income tax is being paid, increasing government tax revenues.

Unemployment is falling, meaning fewer people receive government benefits. Fewer people are in poverty, meaning less spending on transfer payments that support the poor.

These “automatic stabilizers” should mean that as an economy experiences the normal fluctuations of its business cycle, the government budget fluctuates between surpluses and deficits, and over time, national debt is kept nice and low. But as we saw in the graphs linked in the top of this post, a sustained downturn in economic activity can lead to structural deficits that persist for years and years. Persistent budget deficits mean an ever ballooning national debt, as can be seen in this chart:

As the graph above shows, over time, large deficits lead to ever growing debts. Notice the general inverse relationship between the size of a country’s budget deficit and the size of its national debt. Countries in the upper left hand corner of the graph generally have low deficits (or budget surpluses) and enjoy relatively small national debts. In the lower right, on the other hand, large deficits have lead to levels of debt frighteningly large as a percentage of the countries’ GDPs.

Discretionary Fiscal Policy

What does all this mean for government policy makers? Let’s first distinguish between the automatic fiscal policy described above and discretionary fiscal policy. Much of the increase in budget deficits and national debts seen in the charts in this post can be explained by European governments’ initial responses to the economic downturns first seen in 2007 and 2008. When unemployment began to rise and output began to fall across Europe, the first response of many governments was to intervene to try to stimulate aggregate demand beyond what was provided automatically through increased transfer payments and decreasing tax receipts. Discretionary fiscal policy refers to deliberate changes to overall tax rates and government spending aimed at directly or indirectly stimulating (or contracting) demand in the economy to help move an economy back to its full employment level during a recession (or, in some cases, during a period of high inflation).

Discretionary fiscal policy, when used during a recession, will drastically increase the size of a budget deficit (and therefore, the national debt). Why do it, you ask? Advocates of such policies (often known as Keynesians, after John Maynard Keynes, whose theories formed the basis for such policies) argue that a recession must be reversed as soon as possible, or else the burden of a nation’s existing debt will grow (as a percentage of its GDP) as the country’s GDP falls. More importantly, of course, is the human and social cost of a recession, as workers become unemployed and hardship spreads among the nation’s households.

A short-term increase in the budget deficit may pay for itself if the subsequent increase in overall demand is mulitplied throughout the economy and overall GDP increases by more than it would have with only automatic stabilizers to rely on. Government spending on infrastructure, education, health, and other public goods creates jobs, increases household income, provides the economy with new capital and infrastructure, increasing the nation’s production possibilities and boosting demand to move the economy closer to full employment. Higher incomes among those employed in government projects will be spent, creating even more new jobs in the private sector.

Discretionary fiscal policy aimed at stimulating demand requires a government borrows money, increasing the national debt. But if such policies are successful, the debt burden will be smaller over time since economic growth may return, increasing the GDP and thus allowing the budget to move back towards surplus sooner, as automatic stabilizers once again kick in.

Evaluating the use of Fiscal Policy for managing the economy

Understanding the difference between automatic and discretionary fiscal policy, and the impact that expansionary policies have on budget deficits and national debt, provide us with tools for evaluating its use during recessions or periods of high inflation. However, we need to know more about the impact of deficits and debt in order to fully evaluate its use. For that, you’ve got to read some more posts and watch some videos. Here are some key resources that will help you evaluate the use of fiscal policy for fighting recessions.

After watching these two video lectures and reading the post, answer the discussion questions that follow:

Explain the huge increases in national debts (both in Euros and as percentages of the countries GDPs) during the later part of the decade from 2000 to 2010.

How does automatic fiscal policy differ from discretionary fiscal policy?

How does the multiplier effect of fiscal policy provide support to the Keynesians’ views that tax cuts and increases in government spending can highly effective at getting and economy out of recession?

How does the crowding-out effect of fiscal policy support the opponents of its use who argue that government spending and tax cuts will only make an economy less competitive and grow more slowly in the long-run?

About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course.
Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author